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The Japanese yen saw a significant depreciation in 2022. Commentators argue that this is due to global economic uncertainties and rising global commodities prices.

(a) With the aid of a diagram, explain one demand and one supply factor that would cause a depreciation of a country's currency. [10]

The depreciation of a country’s currency can be influenced by both demand-side and supply-side factors in the foreign exchange market. A depreciation occurs when the value of a currency falls relative to another, meaning more units of the depreciating currency are required to buy the same amount of foreign currency. In the case of the Japanese yen’s significant depreciation in 2022, commentators have pointed to global economic uncertainties and rising global commodities prices as key contributing factors.

Global economic uncertainties

One demand-side factor that can cause a currency to depreciate is global economic uncertainty. When global uncertainties rise, such as during periods of political instability, economic recession, or geopolitical tensions, both consumers and firms become more cautious about spending and investing. This often leads to a reduction in demand for exports from countries like Japan. Since foreign consumers and firms need to buy Japanese yen to purchase Japanese exports, a fall in demand for Japanese goods leads to a decline in the demand for the yen in the foreign exchange market.

In addition, global uncertainties can discourage foreign investors from investing in Japanese assets, such as stocks, bonds, or real estate. Foreign investors would typically need to convert their home currency into Japanese yen to make these investments. If foreign investors perceive greater risk due to global uncertainties, they may choose not to invest, reducing the demand for Japanese yen.

This fall in demand for the yen shifts the demand curve for yen in the foreign exchange market leftward, from DD0 to DD1. As a result, the equilibrium price of the yen falls from P0 to P1, leading to a depreciation of the yen (shown in the diagram below).

Rising global commodities prices

On the supply side, rising global commodities prices can also lead to a depreciation of a country’s currency. Commodities such as oil, natural gas, and food are typically priced in foreign currencies, such as the U.S. dollar. When global commodities prices rise, countries like Japan, which are heavily reliant on imports for these essential goods, will need to spend more yen to purchase the same quantity of foreign goods.

Because the demand for global commodities tends to be price inelastic, Japan cannot easily reduce its consumption of these essential goods despite higher prices. Therefore, Japan would need to exchange more yen for foreign currencies to cover the increased cost of commodities. This increases the supply of yen in the foreign exchange market as Japanese firms and the government sell yen to purchase foreign currencies.

An increase in the supply of yen shifts the supply curve rightward, from SS0 to SS1. As shown in the diagram, this shift results in a fall in the price of the yen from P0 to P1, leading to a depreciation.